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CHAPTER V
5 Entrance of Foreign Banks in India and Corporate Governance
5.1 Introduction
Banking in developing economies typically has government-imposed barriers to entry,
especially on foreign banks. Nevertheless, in contrast, foreign banks have made little
inroads into the developing economies of Asia. Claessens et al (2000) suggest that the
entrance of foreign banks actually increases the efficiency of the developing economy
banking sectors. One possible rationalisation of this finding is that foreign banks bring
with them new management techniques, corporate governance mechanisms and
information technologies which domestic banks have to adopt in order to effectively
compete with their foreign rivals (Peek and Rosengren, 2000, p.46). A further benefit
from permitting foreign bank entry is that it may result in a more stable banking system.
Notably, empirical studies by Demirguc-Kunt (1998) and Levine (1999) suggest that that
the presence of foreign banks reduces the likelihood of banking crises and may result in
banks becoming more prudentially sound.
In 2005, the Reserve Bank released the “Road map for presence of foreign banks in
India” laying out a two track and gradualist approach aimed at increasing the efficiency
and stability of the banking sector in India. One track was the consolidation of the
domestic banking system, both in private and public sectors, and the second track was the
gradual enhancement of foreign banks in a synchronized manner. The Road map was
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divided into two phases, the first phase spanning the period March 2005 – March 2009,
and the second phase beginning after a review of the experience gained in the first phase.
However, when the time came to review the experience gained in the first phase, global
financial markets were in turmoil and there were uncertainties surrounding the financial
strength of banks around the world. At that time it was considered advisable to continue
with the current policy and procedures governing the presence of foreign banks in India.
Governor on April 20, 2010, in his Annual Policy Statement for 2010-2011 indicated that
while global financial markets have been improving, various international for a have
been engaged in setting out policy frameworks incorporating the lessons learnt from the
crisis. Furthermore, there was a realisation that as international agreement on cross-
border resolution mechanism for internationally active banks was not likely to be reached
in the near future, there was considerable merit in subsidiarisation of significant cross-
border presence. Apart from easing the resolution process, this would also provide greater
regulatory control and comfort to the host jurisdictions. In the Policy Statement it was
announced “Drawing lessons from the crisis, it is proposed to prepare a discussion paper
on the mode of presence of foreign banks through branch or WOS by September 2010”.
Accordingly, the presence of foreign banks in India has been taken into account, inter-
alia, the lessons learnt from the recent global financial crisis and the practices followed in
other countries.
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5.2. Existing framework
The road map unveiled in 2005 comprised two phases – Phase I (March 2005 to March
2009) and Phase II (April 2009 onwards).
A copy of the “Roadmap for presence of foreign banks in India” released with the Press
Release dated February 28, 2005(Annexure IV).
During the first phase, foreign banks were permitted to establish presence by way of
setting up a wholly owned banking subsidiary (WOS) or conversion of the existing
branches into a WOS. The guidelines covered, inter alia, the eligibility criteria of the
applicant foreign banks such as ownership pattern, financial soundness, supervisory
rating and the international ranking. The WOS was to have a minimum capital
requirement of Rs.300 crore i.e. Rs.3 billion and would need to ensure sound corporate
governance. The WOS was to be treated on par with the existing branches of foreign
banks for branch expansion with flexibility to go beyond the existing WTO commitments
of 12 branches in a year and preference for branch expansion in under-banked areas. The
Reserve Bank had indicated that it may also prescribe market access and national
treatment limitation consistent with WTO as also other appropriate limitations to the
operations of WOS, consistent with international practices and the country’s
requirements.
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5.3. Branches vs Subsidiaries
5.3.i Regulatory control perspective
Recent global financial crisis have brought out that (a) complex structures (b) too big to
fail (TBTF) and (c) too connected to fail (TCTF) have exacerbated the crisis. The post-
crisis lessons support domestic incorporation of foreign banks i.e. subsidiarisation.
Branches are not separate legal entities whereas subsidiaries are locally incorporated
separate legal entities. Subsidiaries being locally incorporated have their own capital base
and their own local board of directors. In the case of branches, parent banks are, in
principle, responsible for their liabilities.
The main benefits associated with branches are (i) greater operational flexibility, (ii)
increased lending capacity (loan size limits based on the parent bank’s capital) and (iii)
reduced corporate governance requirements. Branches are generally not allowed to take
retail deposits or enjoy deposit insurance.
While the branch form of presence can have its own advantages such as stronger support
from the parent could be forthcoming in situations of local adversity of the branch,
internationally it is generally understood that with a branch it may be difficult to
determine the assets that would be available in the event of failure of the bank to satisfy
local creditors’ claims and the local liabilities that can be attributed to the branch. As
branches are part of the head office, assets attributable to it can easily be transferred by
the branch to the foreign head office. Further the management of a branch does not have a
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fiduciary responsibility to the branch’s local clients. In fair weather it may not be of much
relevance but in times of crisis, the distinction between the branch and the rest of the
bank, and the legal location of assets and liabilities, may well become very important.
5.3.ii Cross Border Resolution Issues with branches
Insolvency procedures may differ by the approach taken by each country. Some countries
follow a “separate-entity” doctrine and thus are able to place their depositors and
creditors before those of other countries. For example, Australia and USA have enacted
rules under which home country depositors or creditors are senior claimants over
depositors from branches located overseas during bankruptcy proceedings. Other
countries follow “single-entity” doctrine and consider a bank and its foreign branches as
a whole and give an equal treatment to all creditors irrespective of domicile unlike
Canadian and American legislations that allow the authorities to separate the branch from
its parent and use the assets to cover the liabilities under the host country regulations.
During liquidation of a foreign bank’s branch, US authorities can collect all the assets of
the foreign bank in their jurisdiction, even when those assets do not belong to the branch;
hence, more assets will be available to reimburse the claimants of an ailing foreign bank’s
branch. Moreover, in the case of a bank failure the FDIC is authorized to bill the cost of
the failure to affiliate or sister banks.
In order to overcome these limitations the Cross Border Bank Resolution Group (CBRG)
of BCBS has come out with its recommendations based on the lessons from the crisis,
delineating two approaches viz. ring fencing or territorial approach and universal
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approach. The CBRG recommends a “middle ground” approach that recognises strong
possibility of ring-fencing in a crisis. This approach entails certain changes to national
laws and resolution frameworks. An alternative approach would be establishing a
universal framework for the resolution of cross border financial groups, which puts all
creditors on same footing. Though some jurisdictions including India stipulate locally
assigned capital for branch mode of presence which serves the purpose of ring fencing,
setting up subsidiaries clearly provides for ring fenced capital within the country.
In view of the above mentioned facts a number of jurisdictions therefore impose a local
incorporation requirement for foreign banks mainly for two reasons (i) to protect retail
depositors and (ii) to limit operations of systemically important banks.
In general, following are the main advantages of local incorporation:
(i) it ensures that there is a clear delineation between the assets and liabilities of the
domestic bank and those of its foreign parent and clearly provides for ring fenced capital
within the host country.
(ii) it is easier to define laws of which jurisdiction applies since laws characterize a
subsidiary as a locally incorporated entity with its own capital.
(iii) a locally incorporated bank has its own board of directors and these directors are
required to act in the best interests of the bank, to prevent the bank from carrying on
business in a manner likely to create a substantial risk of serious loss to the bank’s
creditors.
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(iv) local incorporation provides more effective control in a banking crisis and enables
the host country authorities to act more independently as against branch operations.
It must however be recognised that setting up of subsidiaries does not necessarily ensure
support from the parent bank in all weathers. International experience has shown that
“comfort letters” provided by the holding companies is not a source of strength as their
enforceability in times of stress is very often questioned. In fact numerous examples can
be cited from the Argentine crisis and banks such as from Malaysia which abandoned
their subsidiaries when faced with a crisis. Similarly holding companies are not
necessarily a source of support to their subsidiaries in certain circumstances. The
insolvency of a parent or ring fencing of liquidity by parent’s home country regulator can
have same effect on subsidiaries as well as branches. In many instances international
groups manage liquidity centrally and place it with various subsidiaries on a short-term
basis and in such cases the failure of parent necessarily may result in the immediate
failure of the subsidiary.
A down side risk with subsidiaries may arise from financial stability perspective if they
come to dominate the domestic financial system due to their being locally incorporated
entities. It has come to the fore that subsidiaries promoted by foreign banks, where they
had large presence, had not only acquired large share at the expense of domestic banks in
the boom years but when the home countries were afflicted they had tended to
substantially curtail their operations in or withdraw from the host country. Indian
experience in this regard even with branch mode of presence has been no exception as the
foreign banks had withdrawn substantially from the credit markets in India to the extent
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that y-o-y growth of credit was -7.1% (as on July 3, 2009) and -15.9% (as on October 9,
2009). However, through prudential measures, like limiting the size of the foreign bank
branches and subsidiaries, it can be ensured that the domestic financial system is not
dominated by foreign banks.
On balance however weighing the pros and cons of the branch form of presence against
the subsidiary form of foreign banks, the advantages in WOS outweigh downside risks.
In the light of experience gained, particularly, in the recent global crisis, subsidiary form
of presence appears to be a preferred mode for the presence of foreign banks. The
regulatory comfort that local incorporation of WOS provides as compared to the branches
of foreign banks would also justify a preference for WOS.
5.4. Proposed Framework for Presence of foreign banks in India
5.4.i There are currently 34 foreign banks operating in India as branches. Their balance
sheet assets, accounted for about 7.65 percent of the total assets of the scheduled
commercial banks as on March 31, 2010 as against 9.03 per cent as on March 31, 2009.
In case, the credit equivalent of off balance sheet assets are included, the share of foreign
banks was 10.52 per cent of the total assets of the scheduled commercial banks as on
March 31, 2010, out of this, the share of top five foreign banks alone was 7.12 per cent.
5.4.ii The policy on presence of foreign banks in India has followed two cardinal
principles of (i) Reciprocity and (ii) Single Mode of Presence. These principles are
independent of the form of presence of foreign banks and therefore they should continue
to guide the framework of the future policy on presence of foreign banks in India.
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5.4.iii Following factors seem relevant for any framework for future policy on presence
of foreign banks in India:
• Prima facie the branch mode of presence of foreign banks in India provides a
ring-fenced structure as there is a requirement of locally assigned capital and
capital adequacy requirement as per Basel Standards. Certain provisions of the
BR Act also delineate the separate legal identity of branches of foreign banks in
India. Further, under section 584 of the Companies Act, though the company
incorporated outside India is dissolved, if it has ceased to carry on the business in
India, it may be wound up as an unregistered company. However, except for the
assets specifically ring-fenced under Section 11(4) of the BR Act, the claim of
domestic depositors and creditors over other assets is yet to be legally tested.
• Keeping the above in view, on balance, the subsidiary model has clear advantages
over the branch model despite certain downside risks. However, under the extant
policy as laid down in 2005 Roadmap, no foreign bank has approached RBI, for
setting up a subsidiary, may be due to lack of incentives. Hence there may be a
need to incentivise subsidiary form of presence of foreign banks.
• From financial stability perspective there would be a need to mandate at entry
level itself subsidiary form of presence (i.e. wholly owned subsidiary-WOS)
under certain conditions and thresholds. It would likewise be mandatory for those
fresh entrants who establish as branches to convert to WOS once they meet the
conditions and thresholds referred to above or which become systemically
important over a period by virtue of their balance sheet size.
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• While deciding the approach towards conversion of existing foreign bank
branches, India’s commitments to WTO will have to be kept in mind.
• It may not, therefore, be possible to mandate conversion of existing branches into
subsidiaries. However, the regulatory expectation would be that those foreign
banks which meet the conditions and thresholds mandated for subsidiary presence
for new entrants or which become systemically important by virtue of their
balance sheet size would voluntarily opt for converting their branches into WOS
in view of the incentives proposed to be made available to WOS.
• The branch expansion of both the existing foreign banks and the new entrants
present in the branch mode would be subject to the WTO commitments.
5.5. Eligibility of the parent bank
5.5.i Foreign banks applying to the RBI for setting up their WOS/branches in India must
satisfy RBI that they are subject to adequate prudential supervision in their home country.
In considering the standard of supervision exercised by the home country regulator, RBI
will have regard to the Basel standards.
5.5.ii The setting up of WOS/branches in India should have the approval of the home
country regulator.
5.5.iii Other factors (but not limited to) that will be taken into account while considering
the application for setting up their presence in India are given below:
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I. Economic and political relations between India and the country of incorporation
of the foreign bank
II. Financial soundness of the foreign bank
III. Ownership pattern of the foreign bank
IV. International and home country ranking of the foreign bank
V. Rating of the foreign bank by international rating agencies
VI. International presence of the foreign bank
5.6. Entry norms
5.6.i In the light of the experience gained during the recent global financial crisis, it may
be advisable to mandate presence in form of subsidiaries, at least in case of certain
category of banks, on prudential grounds, at the entry point itself. From financial
perspective, therefore, following category of banks may be mandated entry in India only
by way of setting up a Wholly Owned Subsidiary (WOS):
i. Banks incorporated in a jurisdiction that has legislation which gives deposits
made/ credit conferred, in that jurisdiction a preferential claim in a winding up.
ii. Banks which do not provide adequate disclosure in the home jurisdiction.
iii. Banks with complex structures,
iv. Banks which are not widely held, and
v. Banks other than those listed above may also be required to incorporate locally, if
the Reserve Bank of India is not satisfied that supervisory arrangements
(including disclosure arrangements) and market discipline in the country of their
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incorporation are adequate or for any other reason that the Reserve Bank of India
considers that subsidiary form of presence of the bank would be desirable on
financial stability considerations.
5.6.ii Foreign banks in whose case the above conditions do not apply can opt for a branch
or WOS on entry in accordance with the single mode of presence requirement. However,
it would be mandatory for banks which opt for branch mode of presence to convert
themselves into WOS if:
a) any of the conditionalities as mentioned materializes in the judgement of Reserve Bank
of India or
b) they become systemically important by virtue of their balance sheet size. Foreign bank
branches would be considered to be systemically important once their assets (on balance
sheet and credit equivalent of off-balance sheet items) become 0.25% of the total assets
(inclusive of the credit equivalent of off-balance sheet items) of all scheduled commercial
banks in India as on March 31 of the preceding year.
5.6.iii Existing bank branches
As regards the conversion of foreign banks that already have branch form of presence in
India prior to the implementation of the new policy, the regulatory stance would be as
stated, this would imply that the expectation of RBI would be that existing branches of
foreign banks that meet the parameters set out in above, or which are or become
systemically important on account of their balance sheet size exceeding a threshold limit,
would voluntarily convert themselves into WOS in view of the incentives proposed to be
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made available to WOS. It may be mentioned in this context that currently, top five
foreign banks account for more than 70% of total balance sheet assets of foreign banks in
India.
5.7. Full National Treatment
5.7.i For WOS, by virtue of their local incorporation, full national treatment would be
expected. However, this could create risks from financial stability perspective if the
foreign banks come to dominate the domestic banking system. Further, a consolidation
of the domestic banks both in private and public sectors is yet to take place under the
twin approach model articulated in the “Roadmap”. Thus allowing full national treatment
could lead to unintended consequences for the banking sector. It would, therefore, not be
possible nor desirable to provide full national treatment to WOSs of foreign banks.
However, they would be placed in a much better position than the foreign bank branches
operating in India but less then that of domestic banks. This would provide very
significant incentives for the WOS mode of presence of foreign banks in India.
5.7.ii Government of India, Department of Industrial Policy and Promotion (DIPP) has
defined “foreign company” as a company with more than 50 per cent foreign holding.
Therefore, under the FDI policy as set out in Circular 1 of 2010 dated 31st March 2010
issued by DIPP, WOSs of the foreign banks will be treated as foreign owned and
controlled companies. Hence, WOSs of foreign banks will be treated as “foreign banks”.
This would be an additional reason because of which it would not be possible to provide
full national treatment to WOSs of foreign banks in India.
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5.7.iii The extent of full national treatment and limitations thereon in matters like branch
expansion, raising non-equity capital in India, priority sector lending, etc. are given in the
subsequent paragraphs.
5.8. Capital Requirement
5.8.i The minimum capital requirements for WOS on entry may generally be in line with
those that would be prescribed for the new private sector banks. (RBI had issued a
discussion paper on Entry of New Banks in the Private Sector on August 11, 2010 which
inter alia covers the minimum capital requirement for new banks to be licensed in the
private sector). Therefore, the WOS of foreign banks would be treated at par with the new
private sector banks in regard to minimum capital requirement. The WOS shall be
required to maintain a minimum capital adequacy ratio of 10 per cent of the risk weighted
assets or as may be prescribed from time to time on a continuous basis from the
commencement of operations.
5.8.ii The minimum net worth of the WOS on conversion from branches would not be
less than the minimum capital requirement for new private sector banks. They would be
required to maintain a minimum capital adequacy ratio of 10 per cent of the risk weighted
assets or as may be prescribed from time to time on a continuous basis.
5.8.iii For foreign banks with branch mode of presence - both existing and new, the
existing capital requirements will continue for the present i.e USD 25 million.
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5.9. Corporate Governance
5.9.i Any global entity would manage its investments on the basis of their assessment of
the risk / return trade-off and allocate resources across various subsidiaries. The interest
of the shareholders of the parent is the driving force for such decisions. Concerns may
arise when the decisions taken for a subsidiary affect domestic depositors (and domestic
shareholders, if the subsidiary is listed). Independent board members play an important
role in protecting the interests of all stakeholders. Banks must include independent
directors on their boards in order to make sure that management acts in the best interest
of the local institution. Independent directors also ensure sufficient separation between
the board of a bank and its owners to ensure that the board does not have unfettered
ability to act in the interests of the owners where those interests diverge from those of the
bank.
5.9.ii In some countries foreign bank subsidiaries operate like branches focussing above
all on sales, with decision making powers being locally limited and risk –management
being located abroad. To address these tendencies Reserve Bank of New Zealand requires
locally incorporated large entities conduct substantial portion of their business in and
from New Zealand.
5.9.iii As the international experience shows, some of the important factors to be taken
into account before a foreign bank is allowed to set up a subsidiary is the commitment of
its parent to support the subsidiary, the ability of the subsidiary to operate on a standalone
basis even when the parent faces crisis and also that the subsidiary is managed from the
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host country with most of the systems and controls residing within its jurisdiction and not
managed remotely from the Head Office.
5.9.iv In order to ensure that the board of directors of the WOS of foreign bank set up in
India acts in the best interest of the local institution, RBI may, in line with the best
practices in other countries, mandate that (i) not less than 50 percent of the directors
should be Indian nationals resident in India, (ii) not less than 50 percent of the directors
should be non-executive directors, (iii) a minimum of one-third of the directors should be
totally independent of the management of the subsidiary in India, its parent or associates
and (iv) the directors shall conform to the ‘Fit and Proper’ criteria as laid down in our
extant guidelines contained in RBI circular dated June 25, 2004, as amended from time to
time. This would be in line with our roadmap released in February 2005.
5.10. Accounting, Prudential Norms and Other Requirements
5.10.i The WOS will be subject to the licensing requirements and conditions, broadly
consistent with those for new private sector banks.
5.10.ii The WOS will be governed by the provisions of Companies Act, 1956, Banking
Regulation Act, 1949, RBI Act, 1934, other relevant statutes and the directives, prudential
regulations and other guidelines issued by RBI and other regulators from time to time.
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5.11. Raising of Non-equity capital in India
5.11.i In terms of the current guidelines branches of foreign bank do not have access to
the domestic rupee resources to augment their non-equity capital in India. They are
permitted to raise funds from their Head Office for augmenting Tier I and Tier II capital
through Innovative Perpetual Debt Instruments (IPDIs) and debt capital instruments
subject to terms and conditions prescribed for Indian Banks and additional terms and
conditions specifically applicable to foreign banks.
5.11.ii As regards permitting WOS of foreign banks to raise rupee resources through issue
of non-equity capital instruments there can be two views. One view would be that since
WOS is a locally incorporated bank it should have access to rupee resources in line with
the private sector banks. The other view could be that as WOS is a closely held foreign
owned bank it should raise long term resources from the parent foreign bank in the shape
of IPDI and debt capital instruments to demonstrate the parent’s commitment towards the
host country.
5.11.iii As an incentive to foreign banks to set up WOS or convert their branches into
WOS, RBI may allow them to raise rupee resources through issue of non-equity capital
instruments in the form of IPDI, Tier I and Tier II Preference shares and subordinate debt
as allowed to domestic private sector banks.
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5.12. Branch expansion
5.12.i With a view to creating an environment for encouraging foreign banks to set up
WOS, a less restrictive branch expansion policy, though not at par with domestic banks
may be envisaged. Accordingly, differentially favourable treatment to WOS of foreign
banks as compared to the branches of other foreign banks may be put in place on the
grounds of regulatory comfort that subsidiaries would provide.
5.12.ii Therefore, with a view to incentivise setting up of WOS/conversion of foreign
bank branches into WOS, it is proposed that the branch expansion policy as applicable to
domestic banks as on January 1, 2010, may be extended to WOS of foreign banks also.
This would mean that the WOS would be enabled to open branches in Tier 3 to 6 centres
except at a few locations considered sensitive on security considerations. Their
application for setting up branches in Tier 1 and Tier 2 centres would also be dealt with in
a manner and on criteria similar to those applied to domestic banks.
5.12.iii The expansion of the branch net work of foreign banks in India – both existing
and new entrants – who are present in branch mode would be strictly under the WTO
commitments of 12 branches or as may be modified from time to time. The withdrawal of
the current stance of permitting larger number of branches than the commitment under
WTO of 12 branches each year is to incentivize the foreign banks with branch mode of
presence to move to WOS structure.
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5.13. Measures to contain dominance of foreign banks
5.13.i As discussed, there is a downside risk to financial stability of the dominance of
foreign banks over the domestic banking system on account of the near-national
treatment proposed in several respects to WOSs. Therefore, in order to ensure that such a
situation does not come about, certain restrictive measures would have to be put in place.
At present under the WTO commitments, there is a limit that when the assets (on balance
sheet as well as off-balance sheet) of the foreign bank branches in India exceed 15% of
the assets of the banking system, licences may be denied to new foreign banks. Building
on this to address the issue of market dominance, it is proposed that when the capital and
reserves of the foreign banks in India including WOS and branches exceed 25% of the
capital of the banking system, restrictions would be placed on (i) further entry of new
foreign banks, (ii) branch expansion in Tier I and Tier II centers of WOS and (iii) capital
infusion into the WOS – this will require RBI’s prior approval.
5.14. Priority Sector lending requirements for WOS
5.14.i Since the WOS of foreign banks will be locally incorporated banks they should not
be treated very differently from domestic banks in respect of Priority Sector Lending
norm. Priority sector obligations on WOS have, therefore, to be more onerous than for
branches of foreign banks but less than those for domestic banks since they would not get
full national treatment.
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5.14.ii Further, Raghuram Rajan Committee has also recommended giving WOSs same
rights as private sector banks together with requirement to fulfill priority sector lending
norms at par with domestic banks viz. 40% as against 32%.
5.14.iiiIn terms of extant priority sector lending norms foreign banks are required to
extend lending to the priority sector (total) to the extent of 32% (against 40% for
domestic banks) of Adjusted Net Bank Credit (ANBC) or credit equivalent amount of
off-balance sheet exposure, whichever is higher.
5.14.iv Foreign banks play a significant role in financing foreign trade and as a matter of
fact, most of the foreign banks have opened branches to cater to trade-finance. Having
expertise in handling foreign trade, foreign banks have contributed significantly in rapid
rise of cross border trade. Reserve Bank may, therefore, allow WOS of foreign banks also
to classify export finance as a part of their priority sector lending.
5.14.v At present, no target or sub-target for agricultural lending has been prescribed for
the branches of foreign banks. However, keeping in view the role of agriculture in Indian
economy, WOS of foreign banks should also be required to lend to agriculture in India,
as is the case with domestic banks. It is, however, proposed to prescribe a lower sub-
target for lending to agriculture sector by these WOSs, since the branch spread of these
banks will be limited due to their not being given full national treatment. Accordingly, a
lower sub-target at 10% may be fixed for these WOSs against the target of 18 % for
domestic commercial banks.
Analogous to domestic banks, not more than 2.5% out of sub-target of 10% should relate
to indirect agriculture finance. As regards any shortfall in achieving PSL norms, the
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extant instructions applicable to the branches of foreign banks may be made equally
applicable to WOSs of foreign banks.
5.14.vi Following norms are proposed for WOS of foreign banks towards lending to
Priority Sector:
Newly set up WOS of foreign banks may be required to comply with the Priority Sector
Lending (PSL) norms as given below from day one.
5.14. vii WOSs set up by conversion of existing branches of foreign banks
WOS set up by conversion of existing branches may be allowed a transition period of
five years from the year in which they incorporate in India for meeting priority sector
165
lending norms. The following table lays down the proposed roadmap for achieving 40%
PSL target, sub-target of 10% towards agriculture sector by WOSs:
5.15. Use of Credit Rating and Parent / Head Office Support
5.15.iIf the parent is allowed to give explicit guarantees to the creditors for the liabilities
of the subsidiary, it would strengthen the subsidiary structure. In case the subsidiary fails,
the clients who have the guarantees and standby letters of credit (SBLCs) from the parent
bank may be able to recover their dues from the parent thus leaving more assets of the
subsidiary to satisfy domestic claims. However, on the other hand if such a support is
permitted the WOSs would have an unfair competitive advantage over domestic banks in
terms of lending, raising resources from domestic and overseas markets as well as
providing certain niche services like custodial business to FIIs etc. It is, therefore,
proposed to treat WOS of foreign banks at par with domestic banks in this regard.
166
5.15.ii Nevertheless, the parent bank may be required to issue a letter of comfort to the
Reserve Bank, as is required in many jurisdictions today, for meeting the liabilities of the
WOS.
5.16. Tax treatment
5.16.iIt appears that for any Capital Gains Tax arising out of transfer of property,
goodwill and other assets of capital nature to its own newly incorporated subsidiary in
India the provisions of Section 47(iv) of Income Tax Act, 1961 would be applicable to
foreign banks converting their branches into subsidiaries. Foreign banks may approach
the appropriate authority for suitable clarification.
5.17. Declaration of dividends
5.17.i A suggestion has been made that in the initial years of its formation, the WOS
should be allowed to remit profits like a branch in India. Foreign banks with branch
presence in India are allowed to repatriate profits in the ordinary course of their business.
However the wholly owned subsidiaries of foreign banks, being banks incorporated in
India, may declare dividends like domestic banks subject to criteria laid down in RBI
circular DBOD.No. BP.BC. 88/ 21.02.067/2004/05 dated May 04, 2005. In terms of the
said circular general permission has been granted for declaring dividends only to those
banks, which comply with the following minimum prudential requirements.
(i) The bank should have:
* CRAR of at least 9% for preceding two completed years and the accounting year for
which it proposes to declare dividend.
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* Net NPA less than 7%.In case any bank does not meet the above CRAR norm, but is
having a
CRAR of at least 9% for the accounting year for which it proposes to declare dividend, it
would be eligible to declare dividend provided its Net NPA ratio is less than 5%.
(ii) The bank should comply with the provisions of Sections 15 and 17 of the Banking
Regulation Act, 1949.
(iii) The bank should comply with the prevailing regulations/ guidelines issued by RBI,
including creating adequate provisions for impairment of assets and staff retirement
benefits, transfer of profits to Statutory Reserves etc.
(iv)The proposed dividend should be payable out of the current year's profit.
(v) The Reserve Bank should not have placed any explicit restrictions on the bank for
declaration of dividends.
5.18. Setting up of NBFCs by the WOS of foreign banks
5.18.i Under the provisions of Section 19(2) of the Banking Regulation Act, 1949, a
banking company cannot hold shares in any company whether as a pledgee or mortgagee
or absolute owner of an amount exceeding 30 per cent of the paid-up share capital of that
company or 30 per cent of its own paid-up share capital and reserves, whichever is less.
5.18.ii In terms of the extant RBI instructions, which are more restrictive, the investment
by a bank in a subsidiary company, financial services company, financial institution,
stock and other exchanges should not exceed 10 per cent of the bank’s paid-up share
capital and reserves and the investments in all such companies, financial institutions,
stock and other exchanges put together should not exceed 20per cent of the bank’s paid-
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up share capital and reserves. Investments which are made as part of the treasury
operations of banks purely for the purpose of trading can be excluded for the purpose of
the 20 percent cap. Banks cannot also participate in the equity of financial services
ventures including stock exchanges, depositories, etc. without obtaining the prior specific
approval of the Reserve Bank of India notwithstanding the fact that such investments
may be within the ceiling prescribed under Section 19(2) of the Banking Regulation Act.
5.18. iii RBI does not view favourably setting up of subsidiaries or significant investment
in associates for activities that can be undertaken within the bank.
5.18.iv The WOS being a locally incorporated bank may be subjected to the regulations
as applicable to Indian banks detailed above. In the case of WOS approval for setting up
subsidiaries or significant investment in associates will also factor in whether there are
NBFCs set up by the parent banking group under FDI rules for undertaking same or
similar activity.
5.19. Regulatory framework for consolidated prudential accounting and
supervision
5.19.i The regulatory framework for consolidated prudential reporting and supervision,
currently applicable to branches of foreign banks as laid down in circular
DBODNo.FSD.BC. 46/24.01.028/2006-07 dated December 12, 2006 may also be made
applicable to WOS in all cases where NBFCs are promoted by the foreign bank
parent/group of the WOS in India.
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5.20. Mergers / Acquisitions and Dilution of WOS to 74 %
5.20.i In February 2005, the ‘Road map for presence of foreign banks in India’ indicated
that:
i) Foreign banks may be permitted to invest in private sector banks that are identified by
RBI for restructuring. In such cases foreign banks would be allowed to acquire a
controlling stake in a phased manner.
ii) The WOS of foreign banks on completion of a minimum prescribed period of
operation will be allowed to list and dilute their stake so that at least 26 per cent of the
paid up capital of the subsidiary is held by resident Indians at all times. The dilution may
be either by way of Initial Public Offer or as an offer for sale.
iii) After a review is made with regard to the extent of penetration of foreign investment
in Indian banks and functioning of foreign banks, foreign banks may be permitted,
subject to regulatory approvals and such conditions as may be prescribed, to enter into
mergers and acquisition transactions with any private sector bank in India subject to the
overall investment limit of 74 per cent.
5.20.ii The issue of dilution or listing of WOS of foreign banks in India and allowing
mergers and acquisitions of Indian private sector banks by foreign banks or their WOS
may be considered after a review is made of experience gained on the functioning of
WOS of foreign banks in India.
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5.21. Differential licensing
5.21.i In India, the penetration of banking services is very low. Less than 59 % of adult
population has access to a bank account and less than 14 % of adult population has a loan
account with a bank and priority sector provides an avenue for financial inclusion.
Further, as a policy RBI has not so far encouraged banks that do not subscribe to a
business model that supports financial inclusion in general. Reserve Bank of India would
not consider granting differential license to foreign banks seeking entry in 'niche markets,
since if at this stage it is decided to go in for differential bank license for foreign banks, it
may be a setback to the goal of Financial Inclusion which is being vigorously pursued by
RBI.
The draft of Reserve Bank of India (RBI) has big say on corporate governance of foreign
banks in India. According to the draft, global players would handle its investments on the
basis of their assessment of the risk/return trade-off and distribute resources across
various subsidiaries.
The interest of the stakeholder of the parent is the guiding force for these decisions.
“Concerns may arise when the decisions taken for a subsidiary affect domestic depositors
(and domestic shareholders, if the subsidiary is listed). Independent board members play
an important role in protecting the interests of all stakeholders”. Foreign banks must take
in independent directors on their board of director in order to make sure that management
acts in the best interest of the domestic institution.
The independent directors must ensure sufficient disconnection between the board of
director and its owner of the bank to ensure that the board does not have free ability to act
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in the interests of the promoters.
Historically, the RBI appears to have had a preference for allowing foreign banks to
operate in India as branches rather than separately incorporated subsidiaries.
Consequently, most (if not all) foreign banks have been established as branches for the
purposes of banking law as well as company law. Apart from the fact that a branch enjoys
the support, creditworthiness, and solvency of the main entity (as the branch is merely a
part thereof), it was always an intriguing question as to why there was a preference for
thisform.
In the last 5 years, however, RBI has revisited this position and has now expressed (in a
roadmap issued in 2005) a preference for the subsidiary structure rather than the branch
structure for foreign banks to operate in India. RBI has not only looked at the experience
of other countries, but has also closely monitored lessons from the financial crisis.
5.22 CG an important tool for the presence of foreign banks in India
“Presence of Foreign Banks in India”, the roadmap issued by RBI discusses the
advantages of the subsidiary structure. These include clear delineation of assets and
liabilities (from that of the parent), easier identification of laws that apply to the
subsidiary, more effective control and regulation, greater clarity with corporate
governance norms applicable to the subsidiary as well as treatment of assets and liability
during insolvency. The discussion paper also encourages foreign banks with existing
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branches to convert them into subsidiaries.
The paper considers two vehicles for foreign bank expansion — branches and ‘wholly-
owned subsidiaries' (WOS) — and, guided by experience, roots for the latter. Wholly-
owned subsidiaries, unlike branches, can be treated as separate legal entities; locally
incorporated, they have their own capital base and their own local board of directors. In
the case of branches, parent banks are, in principle, responsible for their liabilities but
assets can easily be transferred to head offices and, should the branch fail, it would be
difficult to determine the assets available to satisfy the claims of local creditors.
Managements of the subsidiaries, in short, have fiduciary responsibility to their local
clients, branches do not. Of course, subsidiaries in trouble can be abandoned by their
parents, as some were in the Argentine crisis, or in good times dominate the domestic
system, but with sufficient “prudential measures” the RBI feels confident of maintaining
a level field. But a problem arises: since the RBI would like to “mandate” new entrants as
wholly-owned subsidiaries what happens to existing bank branches?
Here, ambiguity steps in for the paper leaves it to the existing foreign banks voluntarily to
convert their branches into subsidiaries even as regulation would mandate local
incorporation for new entrants the Reserve Bank of India (RBI) issued compensation
guidelines for implementation by private sector and foreign banks that become
operational from the financial year 2012-2013. This approach is consistent with the trend
that corporate governance norms in the banking sector tend to be more controlled than in
other industry sectors. Apart from the fact that the pay of CEOs and wholetime directors
requires the prior regulatory approval, the compensation guidelines set out detailed
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principles to be deployed in order for these to determine senior bankers pay.
The guidelines place emphasis on board’s oversight regarding compensation design and
operation. For example banks must constitute a remuneration committee consisting of
independent directors that frames, reviews and implements the compensation policy. The
guidelines also stipulate operational matters in sufficient detail, including the distribution
between fixed component and variable component of the compensation. It encourages
deferral arrangements in compensations so as to eliminate short-termism in the senior
management’s approach. Other mechanisms, which received significant attention
following the onset of the financial crisis, such as claw back arrangements are also
required to be implemented. Reliance is also placed on greater disclosure of
compensation arrangements, both at a quantitative level as well as qualitative level.
While the guidelines stop short of imposing quantitative limits on pay, they set out
stringent requirements that banks will have to comply with starting the next financial
year.
5.23 Current status, Analysis and Suggestions
Status of Corporate governance implementation by foreign banks in India
After analyzing the annual reports of the various foreign banks, many banks like Abu
dhabi commercial bank, Deusche Bank, Royal Bank of Scotland, Bank of Nova scotia,
followed corporate governance practices and proper disclosure was made in their annual
reports. However it seems that some banks like Bank of America were not really
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observing the CG practices properly five years back, however it was good to see that in
the later years they started giving the due importance to the corporate governance and
made proper disclosure in their annual reports. But interestingly, even today a few
reputed foreign banks like Standard Chartered do not really give any place to Corporate
governance disclosure in their annual reports. Therefore what I can conclude in a nutshell
with regard to foreign banks is that, may be because as per SEBI guidelines, CG
disclosures are mandatory and to be complied only by those companies (here banks)
which are listed in Indian stock exchange therefore that automatically puts the foreign
banks out of its purview. Hence the foreign banks are following the corporate governance
practices as per their discretion after understanding and realizing its importance thereof,
in order to place themselves as globally competitive entity and since the banks are getting
listed in multiple stock exchanges in different countries and carry out operations in
several jurisdictions while the cross-border financial flows seek an assurance of some
commonly understood standards of governance, especially in view of their fiduciary role,
the corporate governance disclosure is gaining importance amongst the foreign banks as
well.
As already mentioned in Chapter three, because of the above reason CG disclosures were
not found in the annual reports of all the foreign banks hence unlike private and public
sector banks, CG index could not be prepared and therefore a proper comparison cannot
be made between public, private and foreign banks with regard to CG disclosure
practices. Hence, the detailed comparative analysis has been made between public and
private sector banks in the following chapter.
Although foreign banks may have a positive impact on banking system stability and
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efficiency, developing economy governments may be reluctant to permit their entry
because they lose some ability to influence the economy. Indeed, foreign banks may be
less sensitive to indirect government requests and pressures than domestic banks (Stiglitz,
1994, p49). The executives of domestic banks may have connections with the country’s
governing elite and may be seeking business or political favours in return for acquiescing
with government requests. Also, the threat of closure is of larger consequence to a
domestic bank then a foreign bank with an international presence. The ability of foreign
banks to ignore government requests may give them a further competitive advantage.
However, there is an argument that the foreign bank penetration could undermine the
ability of the governments to use the banking system to achieve social and economic
objectives. Finally, given that limited entry of foreign banks may lead to increased
competition, which in turn encourages domestic banks to emulate the corporate
governance practices of their foreign competitors, we suggest that developing economies
partially open up their banking sector to foreign banks.
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REFERENCES
Chhibber, P.K., and S.K. Majumdar (1999), Foreign Ownership and Profitability:
Property Rights, Control, and the Performance of Firms in Indian Industry, Journalof
Law and Economics, 42, 209-238.
Discussion Paper- Presence of foreign banks in India Reserve bank of India
La Porta, R., F. Lopez-De-Silanes, and A. Shleifer 1999. Corporate ownership around
the world, Journal of Finance, 54, 471-518.
Press release of Reserve Bank Of India, February 28, 2005 ‘RBI unveils Roadmap for
Presence of Foreign Banks in India And Guidelines on Ownership and Governance in
Private Banks